A shareholder in SandRidge Energy Inc. (SD) said the Oklahoma oil and natural gas company should find new management, making complaints about various issues including “appalling” corporate governance. We have warned for more than a year about SandRidge’s high risk in this area, and its financial statements continue to reflect problematic accounting and board composition, among other things.

TPG-Axon, which holds a 4.5% stake in SandRidge, sent a letter on Nov. 8 to the board outlining offenses ranging from reckless spending to the stock’s 76% price decline since its initial public offering in 2007. The activist investor said the board should consider selling SandRidge, ousting CEO Tom Ward, and replacing some directors with more “credible, independent” people chosen after extensive consultation with large shareholders.

SandRidge responded on Nov. 8 that it is always open to constructive engagement with its shareholders. “While our perspectives on various points made in the letter from TPG-Axon differ in many instances, we agree that SandRidge has valuable assets and that we need to focus on improving performance for shareholders,” SandRidge said. The board added that it was working with management toward that end.

On the same day, SandRidge announced that it had initiated a process to evaluate the sale of its assets in the Permian basin. Ward said Nov. 9 that the plan was not a reaction to TPG-Axon's letter, according to the media.

Some of SandRidge’s board members have relationships that could interfere with their objectivity in addressing such matters. For example, the board’s director Daniel Jordan previously served as an executive at SandRidge’s predecessor Riata Energy, Inc. Meanwhile, SandRidge investors can only elect around one third of its directors each year, which interferes with their ability to replace those who don't serve shareholder interests.

Warning about such problems as well as many others, we put the company on our risk list in October 2011. In another major red flag, SandRidge’s board has approved a number of related party transactions. For example, SandRidge's audit committee chair Everett R. Dobson and Ward are both minority owners in the Professional Basketball Club LLC (PBC), which in turn owns the Oklahoma City Thunder, an NBA team based in the company’s hometown. In September 2008 they entered into a five-year agreement to pay an average annual sponsorship fee of around $3.275 million for advertising and promotional activities related to Thunder.

Ward obtained the right in 2006 to acquire stakes in wells the company drilled. His program has similarities to the one used by Aubrey McClendon, CEO of Chesapeake Energy Corp., where Ward had been COO before leaving for SandRidge in 2006. Reuters reported last spring that McClendon used his program to borrow as much as $1.1 billion in unreported loans over the last three years. Chesapeake has also had corporate governance issues for years, as we noted in past articles, and the company became a founding sponsor of Thunder in 2008.

SandRidge’s financial statements reflected an AGR ® score of 7 in December 2009, indicating higher accounting and governance risk than 93% of comparable companies. Since then the score has risen no higher than a 22, and it was most recently a 2 as of June. In September we added SandRidge to our Investor WatchList, a monthly list of companies with the highest probability of underperformance over the next three to six months.

SandRidge’s management presents its finances in the best light possible at the risk of disappointing investors down the line, rather than taking a more conservative stance. For example, SandRidge follows the full cost method of accounting for oil and natural gas activities, rather than the successful efforts method. While both are allowable under Generally Accepted Accounting Principles, under full cost all direct and indirect acquisition, exploration and development costs are capitalized, while under successful efforts many of these costs are charged to expense as incurred if they do not result in proved reserves.

In the short run, using the full cost method favored by Sandridge improves reported earnings. However, under this method, capitalized costs eventually become subject to a limit, which the company reached in 2008 and 2009. This triggered large impairment charges on their natural gas and oil properties because although proved reserves were revised upwards in 2008, the deterioration in the price of natural gas and oil that year offset the increase.

The situation worsened in 2009, when proved reserves were revised downwards. As of its annual report for the year ended December 2011, SandRidge continued using the full cost method of accounting.

SandRidge’s managers don’t seem likely to change their game without a forceful push. Maybe the team at TPG-Axon will manage to lend a helpful hand in that direction.

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